ESG investing is growing in popularity. The evidence that good ESG scores boost returns may be mixed, but a new approach finds that those companies that see a larger number of negative ESG events have weaker returns. In fact, it may even be possible to predict ESG failures in advance with some degree of accuracy. As such, strong ESG performance may not necessarily boost returns, but a negative events do seem to predict a degree of underperformance. It may be that because a lot of ESG data is less tangible and harder to digest, the market may not incorporate all ESG information about a company.
In his paper, ESG Incidents and Shareholder Value Simon Glossner of the University of Virginia looks at over 80,000 ESG incidents between 2007 and 2017. He finds that firms with more negative ESG incidents underperform the broader market by 2.5% a year, out of sample, or 3.5% a year during the sample period. Either way, that’s an important result, and includes controls to adjust for other variables that could impact the outcome.
The BP Example
For example, he gives the example of BP. The Deepwater Horizon disaster was also a major hit for shareholders, but he suggests that the chances of that incident occurring could be estimated when prior ESG incidents from BP were examined. Glossner’s research applies that approach at scale, across many companies.
There may be a few reasons for this. First off, information on ESG incidents may be hard to process when compared to other sources of information that are found in a company’s quantitative reporting.
Secondly, analysts may be too short term in interpreting ESG behavior, incidents that seem one-off may suggest weaker management and controls processes that can lead to further incidents in future.
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Thirdly, it may be customer driven. A company that sees a bad ESG event, may lose customers over time as those customers hear the bad news, and then seek out more sustainable and ethical products and services. Whatever the reason, it does appear that the stock market underreacts to poor ESG practises.
So though the evidence that good ESG scores boost shareholder returns is potentially mixed, it does seem that bad ESG behavior carries clear costs for shareholders, in a way that can be determined in advance. Over time, as with all drivers of performance, maybe the market will become more adept as incorporating these risks.